Economics of Competition SPRING 2015 MECNX-441-0

Prof. Sandeep Baliga

Competition & Pricing in the Appliance Industry

Kevin Marschall

EMP 98

August 3, 2015

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There are very few home-expenditures that outweigh the purchase of a major home

appliance, and the choices consumers face in making a buying decision seem to be endless.

Product features, price, size, color, and brand are only some of the criteria that consumers

consider when making a sizable investment in an appliance. Equally important to most

consumers is the decision on where to make the purchase. Price and product assortment tend to

lead the consumer’s decision on where to buy, and other ancillary value-added benefits such as

extended warranty’s, installation service, retailer reputation, salesmanship, and repair service

vary significantly from one retailer to the next. Accordingly, traditional retailers are forced to

contend among an increasingly competitive landscape with razor thin profit margins.

Throughout our assessment of the major home appliance sales segment, we will examine

the key external and internal factors that influence market performance. Additionally, we will

analyze the various retailer market segmentation strategies and observe how customers’ buying

behavior is conversely affected. Lastly, we will explore the externalities that exist through the

purchase of new appliances.

Market Analysis:

The economic recovery beginning in 2009 has increased consumer spending, resulting in

a rebound for the major appliance industry. Increased demand is expected to rise at an annual

rate of 0.5% to $18.1 billion (domestic) by year 2020, but it is significantly slower than the rate

of the GDP growth forecasted at 2.5 percent. The strong domestic consumer demand and

strength of the US dollar will create an incentive for large foreign multinational corporations to

take advantage of lower labor costs overseas and export more products to the U.S. As

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competition in the appliance industry continues to strengthen, industry revenue will also

increase, but profit margins are likely to erode.

The industry products (ranges, ovens, cooktops, microwaves, refrigerators, freezers,

washers, and dryers) are typically only purchased when there is a strong incentive to do so.

Consumers with limited discretionary income that own outdated but functional equipment have

little motivation to purchase new machines since the products and features do not change

dramatically enough from year to year to compel consumers to replace working appliances.

However, as consumer confidence continues to increase, households are also expected to

increase their spending on delayed purchases of new appliances.

The housing and home renovation markets have also had a direct impact on appliance

sales. As the housing market recovers, occupancy rates and home improvement expenditures

increase. The quantity of households is climbing faster than the rate of occupants per home,

since younger generations are waiting longer to marry and divorce rates are rising. As the

demand curve for housing and home improvements shifts upwards, the demand for new

appliances moves in tandem. Furthermore, new homeowners and home renovators are more

likely to purchase several major appliances at the same time in an effort to update their homes,

rather than just replacing a single appliance.

Another contributing factor to the recovery of the appliance market is the improvement of

energy efficiency, which makes appliances less costly to operate. Energy costs continue to

increase, and older appliances become less efficient as they age. Consumers are incentivized to

mitigate the energy expense of inefficient machines with the purchase of new appliances that are

Energy Star rated. Many consumers are also motivated to upgrade to more efficient equipment

as a commitment to their environmental impact, and with occasional incentives from energy

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companies. The cost/savings benefit of a new energy efficient appliance may take several years

to realize, but the financial benefits are likely to come sooner than the remaining lifespan of the

replaced appliance.

External Drivers of Market Performance

There are several systemic factors that contribute to the performance of the appliance

industry with risks that are correlated to the domestic economy. The contributing external

drivers to the performance of the appliance market are outlined below:

Disposable Income: Fluctuations in consumer disposable income has a substantial impact on the

consumer demand for major appliances. As disposable income rises, consumers have a greater

amount of discretionary income to spend on new appliances. Conversely, as disposable income

diminishes, consumers become less likely to purchase new equipment. The per capita domestic

disposable income of consumers is likely to rise during 2015 to 2016, resulting in improved

performance of the appliance industry.

Appliance Pricing: Appliance pricing generally fluctuates accordingly with the cost of the

materials used to manufactures appliances, such as plastic, steel, and other metals. As the input

costs of the materials increases, those costs are typically passed on to the retail distribution

channel, which are in turn passed on to the end-user customer. When appliance prices rise

during periods of high demand and strong consumer confidence, retailers are likely to raise

selling prices. This action will increase retailer revenue and profitability; however a market

correction is likely to occur, resulting in a new equilibrium since rising appliance costs will

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weaken the consumer demand. Rising prices, even during a period of strong demand, will have a

net negative impact on the appliance industry performance. Prices for major appliances are

expected to continue to rise during the years from 2015 to 2016.

Housing Starts: The housing bust that occurred from 2006 thorough 2009 decreased the number

of new homeowners and reduced the demand for new appliances. Since appliance sales typically

lag behind housing starts, the appliance industry did not begin to see a recovery until 2011. As

the housing market has mostly recovered, and low-density living has become more

commonplace, the number of households will continue to increase, thus raising the demand for

new appliances.

Internal Drivers of Market Performance

Many internal factors that are specific to the industry pose an idiosyncratic risk to the

performance of the appliance market. These risks affect the performance of the market

regardless of the external market drivers as previously explored. The internal factors that

contribute to the appliance market performance are outlined below:

Increased Imports and Manufacturing Costs: The value of the U.S. dollar has risen compared

to other global currencies. As a result, domestic major appliance exports are expected to decline

while foreign appliance imports are expected to rise to a level equal to 50% of the domestic

manufactured demand.

Additionally, the prices of production materials such as steel and plastics have been

highly volatile over the last five years. As the production input prices increase, manufacturers

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are able to pass on some of that price increase to buyers. However, most mass merchandisers

(Sears, Home Depot, Costco, etc.) have long-term buying contracts that prevent manufacturers

from raising prices fast enough to offset the increased production costs. As a result, industry

profit margins lessen during periods of increased imports and input costs.

Tax Credits: During the recession, the U.S. government passed legislation to encourage the

manufacturing and sales of Energy Star related appliances. Domestic manufacturers received tax

credits for the production and sales of energy efficient machines, while consumers received

government issued rebates. Most of the incentives have expired, though some have been

extended through 2016. Consumers that once had an incentive to purchase a new rebate eligible

appliance are now likely to delay a purchase since there is no longer a time-sensitive financial

motivation. Additionally, since the manufacturer tax credit applied only to appliances built

within the U.S., the manufacturer is now likely to produce more appliances offshore where labor

is cheaper.

Product Innovation and Efficiency: Product differentiation in the appliance industry is low, and

product lines are clearly segmented, which increases competition but keeps profit margins low.

New product innovations by a manufacturer do not remain unique for long, which is why

differentiation is uncommon. However, new innovation does occur generationally among all

manufacturers, which creates a purchase incentive for consumers that are operating appliances

that are functionally outdated.

The appliance industry is also expected to generate sales through the innovation of new

smart appliances that operate when electricity is most affordable, thus reducing consumers’

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electric bills. These appliances interact with smart utility grids, but only function if smart meters

are installed on the owners’ home. Smart meters are only available in limited markets, but as

they becomes more prevalent, consumers will gain a financial incentive to upgrade their

appliances to smart appliances that will offset the rising costs of utility expenses.

Retail Competitive Analysis:

Consumers rate the availability of installation services, convenient location, wide

selection, and low prices relatively equally among their criteria on where to buy an appliance.

However, the importance of these factors is directly correlated with the amount paid (Exhibit 1).

Exhibit 1 (Source: Lightspeed GMI/Mintel)

For entry-level appliance models, low prices and convenience become most important,

shifting the competitive advantage to mass merchants that carry a limited selection of products.

Wholesale clubs (Costco, Sam’s Club) and discount stores (Wal-Mart, Target) carry a limited

assortment of appliances and thrive most efficiently with the entry-level to mid-level price

segment. Since other ancillary services such as installation, delivery, and sales consultations are

not important considerations to the budget consumer, this retail channel gains market share

solely on price leadership. However, online retailers continue to steal market share from this

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segment. Many e-commerce stores are able to offer the same products that are found at discount

brick-and-mortar stores, but at an even greater savings since the operational costs of real estate,

payroll, and SG&A are drastically reduced. Furthermore, the budget-conscious consumer is

afforded the convenience of shopping online from home. Proposed State and Federal legislation

will force many online retailers to charge sales tax to consumers for products that are sold across

State lines. Traditional bricks-and-mortar retailers celebrate this government intervention, as a

mediation that is necessary to level the competitive playing field.

Mid to upper tier appliance model purchasers site wide selection, installation and repair

services, and knowledgeable sales staff as more important than retailer location. Retailers such

as Sears, Home Depot, and Lowe’s stock a diverse brand assortment in the mid to upper price

points. Mass merchants in this category benefit from competitive pricing due to their ability to

purchase large quantities with volume discounts provided by their appliance suppliers. Sears has

remained the top industry leader in appliance sales, although their leadership position is likely to

be overtaken by Lowe’s. Since the price of a home appliance is relatively high, consumers are

likely to perform a thorough due diligence review prior to purchase and are likely to comparative

shop, and read product and retailer reviews (Exhibit 2). Consequently, retailers such as Sears and

Home Depot have leaned heavily on sales promotions and other incentives to prevent consumers

from utilizing their storefronts simply to research and “touch and feel” the product – only to lose

the sale to a lower-priced competitor.

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Exhibit 2 (Source: Lightspeed GMI/Mintel)

Shoppers in the mid to upper tier product category rely heavily on sales staff

recommendations and expertise in choosing an appliance. As such, retailers in this segment offer

diverse ancillary services such as delivery and installation services, haul-away of old equipment,

and extended warranties. The bundling of services creates a centralized point-of-contact for the

consumer, while creating “stickiness” of the customer to the retailer. Furthermore, the bundling

of services increases the retailer revenue by adding on other value-added services, while still

remaining competitive on the appliance pricing. Retailers in this segment aim to attract

consumers who are looking to purchase other consumer products such as apparel, home

improvement items, fitness equipment, home fashions, etc. The value of the customer is based

largely upon the frequency of shopping for all other products, not just the infrequent purchase of

a major appliance.

The reputation for white glove installation, exceptional customer service, professional

salesmanship, and timely repairs after purchase are very important to consumers at the upper tier

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and premium price points. Availability of specific luxury brands (Viking, Wolf, Sub-Zero) is

also cited among the most important retailer attributes for the top-tier appliance segment.

Shoppers in this category are less price-sensitive than other segments, though it is still important

for retailers to be price competitive with one another. Specialty retailers like Abt Electronics, a

single store operator in suburban Chicago, compete at the highest levels of the appliance market

with an exemplary reputation, and establishment of long-term relationships with their customers.

Abt is ranked in first place by Consumer Reports as the best appliance retailer in the country,

despite having just one location (Exhibit 3).

Exhibit 3 (Source: Consumer Reports – June 8, 2015)

Retailers compete on the price of products; quality, product features, styling and

performance; service capabilities and levels; brand name and warranty periods. Price is

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important to consumers that seek the lower end of the market, but is less important to customers

that want the premium appliances.

Externalities in the Retail Appliance Industry

The retail appliance industry is a highly competitive market with few externalities

inherent to the retail strategy. However, there are possibilities for externalities to exist within the

industry at large as technology continues to evolve.

Consumers are placing an increased value on appliances that are enabled to lower their

electricity costs and increase convenience and ease of use. The adoption of smart appliances by

consumers is critical to the success of the transition to the electrical Smart Grid infrastructure.

Smart appliances have the ability to receive, interpret, and act on a signal received from the

electrical utility provider, and automatically adjust operative functions to save energy. Smart

appliances will help bourgeon the Demand Response and Time of Use programs offered by

utilities, reducing the need for additional infrastructure of power plants that produce electricity

only at peak times. Consumers who own smart appliances will benefit from the capability to

better control energy usage through the seamless operation during off-peak hours.

A positive externality for consumers is created through the adoption of the Smart Grid /

Smart Appliance technology. Smart meters that communicate directly with smart appliances

inside the home will lower customer’s electrical demands during peak periods, thereby

contributing indirectly to demand response initiatives. As adoption becomes widespread, the

potential to reduce carbon emissions and relieve the burden of power plants during peak periods

will benefit all members of society. The net result of this externality is cleaner air and water,

reduction in global warming, reduced CO2 emissions, and lower energy costs.

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Adoption of the Smart Grid and enabled appliances has been slow. Smart appliances are

useless without the installation of a smart electrical meter upgrade to the consumer’s home.

Utilities have been slow in incurring this expense with only some markets that have completed

the upgrade. Furthermore, consumers are not well educated on the benefits of the technology

and are therefore reluctant to invest in the incremental expense of smart appliances. The

technology will eventually flourish in American homes, but it will take several years for this to

reach the critical mass.

Conclusion:

The appliance industry is highly competitive and dependent on economic factors such as

housing, cost of raw materials, and currency rates. In order for manufacturers to remain relevant,

they must continually innovate through technology and energy efficiency, so that consumers

have compelling reasons to replace and upgrade appliances. Retailers – both brick and mortar

and online businesses – must ensure they carry the most innovative and appealing brands, while

investing in their sales staff, promotional materials, and websites to compete effectively. Sears

will only face increasing competition in the appliance category, so their relevance in this space

depends on their ability to stay ahead of other big box and Internet retailers.